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Market plunge seen as healthy

Experts say the bull market, dating back to 2002, was overdue for a correction.

Associated Press
Published March 1, 2007

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NEW YORK - As difficult as it might be to explain to investors who lost a total of $632-billion in Tuesday's market carnage, a correction isn't necessarily a bad thing. It may have reacquainted investors with the concept of risk.

"Corrections like this are the financial equivalent of castor oil," said Hans Olsen, chief investment officer at Bingham Legg Advisers in Boston. "It's good for you, you don't like it, but you have to take it."

A day after a 416-point plunge in the Dow industrials, Wall Street rebounded fitfully Wednesday as investors took comfort from comments by Federal Reserve Chairman Ben Bernanke, who said he still expects moderate economic growth, but still showed signs of unease about the economy.

"It's typical that you get a bounceback the next day," said Joseph V. Battipaglia, chief investment officer at Ryan Beck & Co. "Now we're essentially flat on the year. Can we go up from here or down? That sorting-out process will continue now."

A recovery in China's Shanghai Composite Index, which had fallen nearly 9 percent Tuesday, also helped boost U.S. stocks, although other Asian markets and European exchanges saw declines of more than 1 percent.

Stock market rallies are psychological in nature, and the exuberance of investors to get in on a good thing feeds more buying. Soon, exuberance overcomes rational measures of the market's health, such as earnings growth. Share prices no longer reflect the risk of a slowing economy or weaker profit growth.

Risk readjustment

When that risk is finally understood, stock prices readjust.

Over the past six months - until Tuesday, that is - the Dow Jones industrial average surged 17.6 percent without any kind of meaningful pause. That's a long time for the stock market to go without a reality check.

"The sell-off reintroduced the concept of risk to the market that had been absent for quite some time," said Russ Koesterich, senior portfolio manager at Barclays Global Investments in San Francisco. "Investors very quickly and violently reappraised their appetite for risk."

In this market, they also recover from the blow quickly, as evidenced by Wednesday's strong showing by the Dow. According to Citigroup, when stocks have fallen 3 percent in one day, they've recovered handsomely within three months 80 percent of the time.

With investors now taking risk into account, the question now becomes whether the long-term market rally can continue - or whether it's heading for a full-fledged bull market correction. In bull markets, a correction represents a 10 percent drop in stock prices. The current bull market dates from Oct. 9, 2002, and has yet to experience a correction.

Like short-term rallies, long-term bull market corrections are seen as a positive for the health of the bull market. Such events weed out poor investments and allow would-be buyers to seek entry points into the market at more reasonable prices.

Bernanke's buoying words

Federal Reserve Chairman Ben Bernanke faced his first market crisis with a calm, matter-of-fact demeanor that won praise from lawmakers and economists alike. Testifying the day after the market's 416-point plunge, Bernanke told the House Budget Committee that the Fed was monitoring market developments but had seen nothing that would cause it to change its positive outlook for the economy. Discussing market operations, he said, "They seem to be working well, normally." The possible causes put forward by analysts have ranged from a record drop in China's Shanghai index, a surprisingly weak manufacturing report in the United States and weekend comments by former Fed chief Alan Greenspan that had raised the possibility of a U.S. recession by year's end. "There didn't seem to be any single trigger of the market correction we saw yesterday," Bernanke told the House panel. Investors on Wall Street liked what they heard.